TransDigm Group Inc (TDG) 2017 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q3 2017 TransDigm Group Incorporated Earnings Conference Call. (Operator Instructions)

As a reminder, this conference is being recorded for replay purposes.

It is now my pleasure to hand the conference over to Ms. Liza Sabol, Investor Relations. Ma'am, you may begin.

Thank you, and welcome to TransDigm Group Incorporated's Third Quarter -- excuse me, thank you all for calling in today, and welcome to our third quarter earnings conference call. With me on the call this morning are TransDigm's Chairman and Chief Executive Officer, Nick Howley; President and Chief Operating Officer, Kevin Stein; and Chief Financial Officer, Terry Paradie.

A replay of today's broadcast will be available for the next 2 weeks. Details are contained in this morning's press release on our website at transdigm.com.

Before we begin, we would like to remind you that statements made during this call which are not historical in fact are forward-looking statements. For further information about important factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements, please refer to our latest filings with the SEC available through the Investors section of our website or at sec.gov.

We would also like to advise you that during the course of the call, we will be referring to EBITDA, specifically EBITDA As Defined, adjusted net income and adjusted earnings per share, all of which are non-GAAP financial measures. Please see the tables and related footnotes in the earnings release for a presentation of the most directly comparable GAAP measures and a reconciliation of EBITDA, EBITDA As Defined, adjusted net income and adjusted earnings per share to those measures.

With that, let me now turn the call over to Nick.

Good morning, and thanks to everybody for calling in. Today, I'll start off, as always, with some comments about our consistent strategy. I'll give a little color on our commercial aftermarket business and a few other topics relating to Q3. I'll summarize the Q3 '17 performance and give some color on the guidance. Kevin will then give us significantly more detail on the operations in Q3, and Terry will run through the financials.

To restate, we believe our business model is unique in the industry, both in its consistency and its ability to sustain and create intrinsic shareholder value through all phases in the aerospace cycle.

About 90% of our net sales are generated by proprietary products, and about 3/4 of our sales come from products for which we believe we are the sole-source provider.

Over half of our revenue and a much higher percent of our EBITDA comes from aftermarket sales. Aftermarket revenues have historically produced higher margins and have provided relative stability through the cycles.

Our long-standing financial goal is to give our shareholders over time private equity-like returns with the liquidity of a public market. To meet this goal, we have to stay focused on the details of operating management and value creation as well as careful management of our balance sheet and allocation of our capital.

We follow a consistent, long-term strategy. First, we own and operate proprietary aerospace businesses with significant aftermarket content. Second, we have a simple, well-proven, value-based operating strategy based on our 3 value-driver concept. Third, we maintain a decentralized organization structure and a unique compensation system that is closely aligned with our shareholders. Fourth, we acquire proprietary aerospace businesses with significant aftermarket content where we see a clear path to PE-like returns. And lastly, we view our capital structure and capital allocation as a key part of our effort to create shareholder value.

As you know, we regularly look closely at our choices for capital allocation. To remind you, we basically have 4, and our priorities are typically as follows: first, invest in our existing businesses; second, make accretive acquisitions consistent with our strategy and where we see our rigorous return requirements are met; third, give the money back -- extra money back to the shareholders either through special dividends or stock buybacks; and lastly, pay off debt. Given the low cost of debt, especially after tax, this is still likely our last choice in today's capital markets. Depending on the specific business and capital market conditions, we'll allocate our capital and structure our balance sheet in a manner that we think has the best chance to maximize the return to the shareholders.

To the point of capital allocation, fiscal year '17 is a slower year for acquisitions. As a result, with our financing announcement of today, we expect to give back to our shareholders in fiscal year '17 almost $3 billion, or between $50 and $55 a share, through a mix of special dividends and buybacks. This is almost 20% of the market cap at the start of fiscal year 2017.

Our liquidity is strong and the credit markets continue to be very attractive. After this next anticipated payout, we will still have significant acquisition capacity, and our acquisition capacity grows steadily through the year. Terry is going to give you a little more detail on that.

To update you on a few recent items of significance in the third quarter, first let me address the commercial aftermarket.

Commercial transport-sized airplanes make up over 85% of our commercial aftermarket. We saw a 7.5% pickup this quarter in our total commercial transport aftermarket, that is passenger, freight and interiors revenues, in spite of a continuing down drag from reduced interior retrofit, our revenues and our 2 primarily interior businesses.

The biz jet, GA and helicopter aftermarkets were down significantly in Q3 versus the prior year. In total, commercial aftermarket revenues were up about 5% versus prior year Q3. Year-to-date total -- in total, commercial aftermarket bookings continue to run ahead of shipments.

For the full year, though we could get close, I think it's unlikely that we get to mid-single digits full year commercial aftermarket growth. The combined commercial transport aftermarket will exceed the 5% full year growth. And if it was not for the softening discretionary retrofits -- interior retrofits, it could well -- it could be well above. However, the discretionary interior business continues to decline more than we expected at the start of the year or at mid-year. Also, the business jet and helicopter market is softer than we originally anticipated. Kevin is going to expand on this in some detail. He's going to try a new format. We'll see how it works. This generally follows our recent presentation on real growth. We'll decide in the future whether to continue using this format.

As an update on our government business, to remind you, direct sales to the U.S. government make up about 7% of our revenue. That's both directly and through distributors or brokers.

The IG, or Inspector General, office informed us and has now made public that due to congressional inquiry, they have initiated an audit of government buying agency compliances with contracting procedures for certain TransDigm awards. We will cooperate fully, as we have done in the past with these. We have been in contact with the IG office to offer our cooperation. As I mentioned last quarter, these audits are common in the industry and are typically audits of the internal government purchasing procedures.

I can't comment any more specifically. These audits typically go slowly. This will likely take well over a year to conclude. I will not comment further on this unless we decide a public disclosure is appropriate.

In Q3, we completed the acquisition of 3 product lines for a little over $100 million. These product lines are all proprietary aerospace products with significant aftermarket. All 3 will be relocated to existing TransDigm businesses. To give a little more color, the mechanical actuator product line will be moved into our AeroControlex business in Ohio, the quick disconnect product line will be moved into our AdelWiggins business in California and the databus product line will be moved into our DDC business in New York. We anticipate all 3 of these should well exceed our acquisition return criteria.

Our acquisition efforts remain active. The pipeline is, as usual, mostly small and midsized businesses. And as usual, closings are always tough to predict.

A quick overview of the third quarter.

On a same-store basis, and assuming we own the same mix of businesses in both time periods, commercial OEM revenues were slightly down in Q3 versus the prior year. Commercial transport revenues were up a little, but the continuing soft business jet and helicopter revenues pulled the overall down. As I said before, the total commercial aftermarket was up 5% in the quarter and is now up about 2.5% on a year-to-date basis. Defense revenues continue to be better than we originally forecast in both shipments and bookings.

EBITDA As Defined operating margins were strong and up in both Q3 and year-to-date. We are leaving our full year guidance unchanged. So far this year, we have increased the EBITDA As Defined guidance about $20 million since our initial guidance. This was primarily due to improved operating performance.

The midpoint of the 27 (sic) [2017] revenue guidance remains at $3.55 billion, the midpoint of the EBITDA As Defined remains at $1.7 billion and the midpoint of the EPS as adjusted remains at $12.21.

On a pro forma or same-store basis, the guidance is based on the following slightly revised growth rate assumptions with minor puts and takes. The commercial aftermarket revenue growth is now anticipated to be in the low to mid-single digits versus prior year. Again, the business jet and helicopter market and the discretionary interior retrofit is pulling this average down a bit. This is a modest decrease from our last quarter. The defense and military revenue is up in the low to mid-single-digit percent versus prior year. This is an increase in our assumptions from the last quarter. Commercial OEM revenue growth is now anticipated to be in the low single-digit percent. This is also down a little from our original assumption to start the year. The business jet and helicopter market continues down, and the commercial transport is a little soft.

In summary, Q3 was a strong quarter, and the first 3 quarters of Q7 were solid. It looks like for the full year, commercial revenues will be a little lower than we originally anticipated, but this will be primarily offset by higher defense revenues.

And with that, let me hand this over to Kevin.

Thanks, Nick, and good morning to everyone.

As Nick stated, Q3 of fiscal year 2017 was a strong quarter. Now let me touch on the details of the quarter and provide some color where necessary.

For Q3, total company GAAP revenues and EBITDA As Defined were strong, with revenue up about 14%, EBITDA As Defined up over 15%. EBITDA As Defined was strong at 49% of sales. The strength in EBITDA As Defined as a percentage of sales was due to the continued realization of our value-drivers concept across our core, our base businesses and the continued integration of recent acquisitions.

Now let's review our revenues by market category.

For the remainder of the call, I'll provide color commentary on a pro forma basis versus prior year Q3. In the commercial market, which makes up about 70% of our revenue, we will split our discussion into OEM and aftermarket.

In our commercial OEM market, revenues were down slightly, less than 1%, compared with Q3 of fiscal year 2016 and down even less year-to-date. Commercial transport OEM revenues, which make up most of our commercial OEM revenue, were up slightly versus prior year Q3 and by a similar amount year-to-date. As we have said previously, inventory management by our OEM customers, much of which appears due to rate reductions on wide-body platforms, have created headwinds in the commercial OEM market. We will continue to watch trends for any indication of sustained weakness to further modify our cost structure as necessary.

Business jet and helicopter revenues make up about 15% of our commercial OEM revenues. In total, year-to-date revenues in this market remained down mostly compared to the same period in fiscal year 2016. No sustained recovery in this market has yet been observed. Although new business awards and bookings continue for key future platforms, such as Cessna Longitude, General Dynamics G500 and 600 and the Bombardier Global 7000 and 8000.

Now moving on to our commercial aftermarket business.

As Nick has already summarized, total commercial aftermarket revenue and bookings expanded by about 5% in Q3 fiscal year 2017 when compared to prior year Q3.

Now let me provide a little color on our commercial aftermarket business.

As we have discussed recently, we split the total commercial aftermarket into 4 pieces in an effort to provide color and clarity on this important market for TransDigm. Please see the year-over-year commercial aftermarket revenue growth chart on Page 6 in our earnings call presentation materials on our website.

Commercial transport passenger aftermarket revenue is the largest market segment in our commercial aftermarket revenue at about 60% of sales. For the current quarter, this slice of the commercial aftermarket business grew by a robust 12% when compared with the same quarter in fiscal year 2016 and year-to-date have expanded at 8%. This compares similarly to our previous 3-year average growth at about 10%.

Now for the commercial transport interiors aftermarket, which accounts for about 10% of our total commercial aftermarket revenue. Q3 revenues declined by about 19% when compared with Q3 fiscal year 2016 and year-to-date have declined by approximately 14% compared to a similar period in fiscal 2016. This discretionary interiors market has had a very difficult year-to-date after experiencing robust growth of 14% year-over-year average for the last 3 years. Softness in this market can be traced to a decline in various fleet refurbishment projects. Although we continue to win refurbishment orders for the future, they are now getting rescheduled or delayed, and it is still unclear how long this lull will persist.

For the commercial transport freight aftermarket, which accounts for about 15% of our average revenues in total commercial aftermarket, Q3 demonstrated robust growth of 9% year-over-year. Q3 was our first good quarter so far this year in freight. Bookings as well have started to accelerate as year-to-date, we are up in the freight aftermarket by approximately 18% when compared with fiscal year 2016. This is encouraging, though too soon to tell. Perhaps, the freight aftermarket is finally showing signs of a slow recovery. Our proprietary Telair products are very strong, but we still see weakness in our nonproprietary containers and nets businesses.

To clarify then, commercial transport passenger, interiors and freight pieces make up the commercial transport subsegment we have reported on previously on our commercial aftermarket discussions.

Finally, for the business jet/helicopter aftermarket, which accounts for the final 15% of our revenue of our total commercial aftermarket, sales are down about 9% in Q3 and down about 5% year-to-date compared to the same period in fiscal year 2016. Year-to-date, our order book is about flat with the same period a year ago. There is some indication that this market could improve in the future given business jet takeoff and landing cycles improvement in recent months. But as of yet, we are not seeing this take off, no pun intended. The aftermarket in this segment tends to go through the OEM, and as such, we do not have the same insight into this piece of the market.

So to summarize on our total commercial aftermarket. First, the passenger segment is demonstrating continued strength. Our freight segment is now showing a -- some solid signs of recovery for these proprietary, highly engineered products. And finally, business jet/helicopter and our discretionary interiors market show no clear sign of a recovery as yet.

Now let me speak about our defense market, which remains relatively unchanged at about 30% of our total revenue.

Nick has already reviewed our total defense revenues for fiscal year '17 Q3. Again, this includes both OEM and aftermarket revenues, which were up about 8% versus prior year Q3 and greater than 4% year-to-date, a solid story in both OEM and aftermarket segments of the defense market. Although this uptick is largely spread across TransDigm businesses, 2 locations do stand out: Whippany Actuation Systems had some large shipments for a new confidential OEM defense opportunity and Data Device Corporation, DDC, for aftermarket shipments across a number of key platforms.

Total defense bookings continue to provide an encouraging narrative as bookings have grown about 7% year-to-date compared to the same period in fiscal 2016. Fiscal year 2017 year-to-date OEM bookings have been bolstered significantly by the aforementioned large multi-year new product booking for Whippany Actuation Systems on that confidential platform and for Airborne Systems North America in Q3 for a large order from the U.S. Army for an RA1 special operations parachute. As always, lumpy bookings and shipments like these are common in the defense market, and caution must be used in forecasting off of a few data points.

Moving to profitability and on a reported basis. I'm going to talk primarily about our operating performance or EBITDA As Defined.

The As Defined adjustments in Q3 were noncash compensation expense and acquisition-related expenses. Our EBITDA As Defined of about $443 million for Q3 was up greater than 15% versus prior Q3. In EBITDA As Defined margin of about 49% of revenues for Q3, EBITDA margin excluded the dilution from the impact of acquisitions purchased since 2016 and was about 50%. This indicates that our base business continues to find opportunities to drive improvement within our value-drivers and recent acquisitions are coming up the curve quickly.

Finally, I thought I'd provide an update on our 2016 acquisitions. And to remind you, those were Breeze-Eastern, Data Device Corporation and Tactair, as these have now been in the family long enough to show some results. Specifically our value-driver concept focused around profitable, new business generation, productivity in our operations and value-based pricing. We will update on the more recent acquisitions at a future date once they have more time in the saddle.

We acquired Breeze-Eastern in January of 2016 and have successfully implemented our culture and value driver strategy across the fiscal year. As a reminder, Breeze is a leading global designer and manufacturer of high-performance lifting and pulling devices for military and civilian aircraft and has a stand-alone operation in Whippany, New Jersey. We continue to see good progress this year on all 3 of TransDigm value-drivers. We have streamlined our price lists while extending more value-added services in our aftermarket repair and overhaul offerings.

Our productivity initiatives continue to gain traction as the cost structure is now aligned with our TransDigm business model and has included significant cost reduction actions at Breeze-Eastern since the acquisition. Business unit teams have been formed at Breeze involving a cross-functional customer support team structure. Overall, Breeze-Eastern continues to exceed our acquisition expectations as our margins have expanded, with value generation and EBITDA above our acquisition model.

Data Device Corporation, located in Bohemia, New York, on Long Island, was acquired by TransDigm in June of 2016. As a reminder, DDC is the world leader in the design, manufacture of high-reliability databus, motion control and solid-state power controller products for aerospace and defense vehicles. This capability allows them to deliver the smallest, lightest and highest-performing products in the most cost-effective packaging for these applications in the aerospace market. DDC consists of 6 global manufacturing locations today in the U.S., U.K. and Mexico, including the recent databus product line acquisition. To date, we have aligned the DDC structure with TransDigm's operating strategy and culture and have created focused product lines.

Around our value-drivers, we have implemented a headcount reduction to better rationalize our cost structure and have additionally conducted an extensive review of pricing, contractual opportunities and new product initiatives to drive value generation. Recent product development design wins have seen the continued migration of the DDC family of products into commercial applications, with new design wins this year for 777X, which augment prior wins on the 777X platform and the A350 platforms.

At just over 1 year under TransDigm, the DDC team has done an excellent job at integrating into TransDigm. The business margins have now expanded, with value generation and EBITDA again ahead of our acquisition model expectations.

And finally, on Tactair, which is a world-class designer and manufacturer of electromechanical, hydraulic and pneumatic motion and fluid controls for the aerospace and industrial gas turbine industries. Tactair was acquired in September of 2016, and over the past 10 months, the company has made significant progress integrating itself into the TransDigm culture and adoption of our value drivers. The strong, preexisting management team has organized the business within the TransDigm structure around focused P&L units. EBITDA margins since acquisition are up significantly as a result of the successful rollout of our value-based pricing strategy; a broad cost reduction effort, reducing both product cost and non-production spending, including a significant reduction in headcount; and a focus on the introduction of profitable, new business. To date, this acquisition has delivered value generation and EBITDA ahead of our acquisition model.

So let me conclude by stating all in all, Q3 of fiscal year '17 was another solid quarter for TransDigm, and our acquisitions made in 2016 have met or surpassed our acquisition performance and value generation models.

With that, I would now like to turn it over to our Chief Financial Officer, Terry Paradie.

Thank you, Kev. I will now review our financial results for the quarter.

Third quarter net sales were $908 million or approximately 14% greater than the prior year. The collective impact of acquisitions represented $87 million of the increase in sales. Organic sales were approximately up 3% for the quarter.

Our third quarter gross profit was $522 million, an increase of 18%.

Our reported gross profit margin of 57.5% was almost 2 margin points higher than the prior year primarily due to the strength of our proprietary products and continually improving our cost structure.

Our selling and administrative expenses were 12.2% of sales for the current quarter compared to 11.8% in the prior year. Excluding acquisition-related expenses and noncash stock compensation, SG&A was about 10.7% of sales compared to 9.7% of sales a year ago. The higher SG&A was primarily related to higher selling and admin costs of the recent acquisitions.

We had an increase in interest expense of approximately $31 million, up 26% versus prior year quarter. This is a result of an increase in the weighted average total debt to $11.2 billion in the current quarter. We still expect our full year fiscal '17 net interest expense to be approximately $600 million.

Moving on to taxes. In Q4 fiscal '16, we adopted a new accounting standard related to the accounting for excess tax benefits for share-based payments, including stock option exercises and dividend-equivalent payments. As a result, our GAAP tax rate will now generally approximate our cash tax rate during an entire fiscal year.

Our GAAP effective tax rate was 28.1% in the current quarter compared to 17.3% in the prior year. The higher effective rate in the quarter was primarily due to a lower level of stock option exercises in the current year quarter. We now estimate our full year GAAP tax rate to be around 27%. Our effective tax rate, excluding the accounting standard charge, has not changed and is still estimated to be around 31%. To remind you, this is the rate we use in calculating our full year adjusted EPS.

Our net income for the quarter increased $8 million or 5% to $169 million, which is 18.6% of sales. This compares to net income of $161 million or 20.1% of net sales in the prior year. The increase in net income primarily reflects the increase in net sales and improvements in operating margin, partially offset by higher interest expense and the tax rate versus the prior period.

GAAP EPS was $3.08 per share in the current quarter compared to $2.88 per share last year. Our adjusted EPS was $3.30 per share, an increase of 6.8% compared to $3.09 per share last year. Please refer to Table 3 in this morning's press release, which compares and reconciles GAAP EPS to adjusted EPS.

Now switching gears to cash and liquidity.

We ended the quarter with $971 million of cash on the balance sheet. Our cash balance was impacted by 2 items Nick briefly mentioned. First, we spent $50 million to repurchase approximately 206,000 shares during the quarter at an average price of $2 -- $243 per share. Second, we also paid approximately $105 million for the acquisition of the 3 product lines during this quarter.

We have $600 million in undrawn revolver, $100 million of available under our AR securitization and additional capacity under our credit agreement.

The company's net debt leverage ratio at quarter-end was 6.1x our pro forma EBITDA As Defined, and gross leverage was 6.6x pro forma EBITDA.

As announced in our earnings release this morning, we plan to raise $1.8 billion in new term loans, with proceeds to be used together with cash on hand to repurchase $1.2 billion of our existing tranche C term loans due in 2020 and to fund a potential special dividend in the range of $1 billion to $1.25 billion.

At September 30, 2017, assuming the completion of these transactions, we expect to have dry powder between $1 billion and $1.25 billion available for acquisitions. This capacity increases each quarter ratably, and we expect to increase -- we expect this to increase to over $3 billion by the end of fiscal year '18.

We expect our year-end cash balance between $500 million and $750 million and our net leverage to be between 6.4 and 6.6x at the end of the year, depending on the size of the dividend. In addition, we are seeking to amend our credit agreement to give us the option to buy back shares or pay special dividend for the upcoming next 12 months.

With regards to our guidance, we still estimate the midpoint of our GAAP earnings per share to be $9.28. And as Nick previously mentioned, we estimate the midpoint of our adjusted EPS to be $12.21. Please see Slide 11 for a bridge detailing the $2.93 of adjustments between GAAP to adjusted EPS related to our guidance.

Now I'll hand the call back to Liza to kick off the Q&A.

Thank you, Terry. Operator, we are now ready to open the lines.

(Operator Instructions)

And our first question will come from Noah Poponak with Goldman Sachs.

So I guess how sustainable should we view this 8% in defense to be? Because on the one hand, it seems like a lot of the fundamental drivers of that business for you are picking up meaningfully. On the other hand, it sounds like you're calling out maybe some onetime drivers in the quarter.

Yes. I guess -- Noah, this is Nick. I think the best we can do there is give you the guidance for the year. I don't want to start to forecast into '18 at this point. Yes, but we -- but I'll say we feel better about it than we did a year or 2 ago.

The parachute piece that you called out specifically, I mean, if you look at that budget for the Army, and you mentioned the Army there, that had a much greater than 50% peak to trough on you, and it looks like it's actually scheduled to pick up significantly kind of starting now. So was that a onetime thing? Or is that actually just the beginning of a recovery in that market for you?

Go ahead, Kevin.

I'm not sure -- Noah, I'm not sure what budget. You mean the parachute budget?

Yes. Yes, if you look at the U.S. Army parachute purchases.

I don't know the answer to that, yes. Yes.

I did want to...

I mean, they're fairly active. That business is fairly active in bidding, but I don't have comparison to what's the government budget.

So it's fairly active in bidding? It's not like you just got that one order and then it bounced back?

That's right. That's right. But that doesn't mean you win them. But...

Sure. Okay. And then just on the aftermarket side of the commercial business, commercial aerospace aftermarket, is it possible to lay out for us -- I know you gave us a lot of detail there. I appreciate the incremental detail. But is it possible to lay out in the interiors business and then in the business jet/helicopter piece when they first started declining or, said another way, when you annualize the sharp rates of decline there? That way, we could better understand when they stop being at least the sizable headwinds that they are today.

I don't -- well, Kevin, let me try, and if you have a different -- well, let me take the business jet and helicopter. The business jet/helicopter business, Noah, continues to surprise us in its decline. So my sort of forecast on where I think it is, I would -- if I were you, I'd take with a grain of salt. I would say we don't get -- as Kevin said, more of the aftermarket in the business jet world goes through the OEMs than it does in the rest of our business. So we don't get a whole lot of clarity on it. And it's -- it can at times get a little confused with the OEM buys. You have to sort of parse it out to make a judgment on it. I don't know. It doesn't help you other than to say it -- on the interiors business, I'd like to say, Kevin, I don't think we feel comfortable that we've -- we're seeing a bottom there yet.

Yes, that's right. And I would say, Noah, that, that started to alter itself this year. So that's relatively recent. But the business jet, the weakness that's been ongoing, we're on the right programs. We're winning. As I listed the -- a list of the key business jet sort of platforms for the future, it's -- any recovery there, we're just not seeing it yet.

Okay. So the business jet helicopter piece, you show up 2% '14 to '16. So maybe that started to bleed on you in '16 or even '15. So not insanely difficult comparisons there but still kind of bleeding lower. And then the interior piece being up 14% '14 to '16 and then down sharply, sounds like that's only 2, maybe 3 quarters in. So still another 1 or 2 quarters before that annualizes.

That seems reasonable.

Yes, I agree.

That seems reasonable. And I think, as Kevin pointed out, we're still seeing projects and activity.

Absolutely.

Things just seem to keep getting delayed or move around.

Yes.

Our next question will come from the line of Myles Walton with Deutsche Bank.

Can we have a clarification on the orders for freight first? I think you said bookings were up 18%. Is that year-on-year? And is that year-to-date or in the quarter?

Yes. So that's -- the 18% is year-to-date.

Year-to-date? Well, okay. All right. And then the other one, Terry, the EBITDA margins, I think you had, on the last call, implied the -- and certainly, the guidance sort of imply a bit of a tick down in EBITDA margins As Defined. And obviously, they are pretty strong here, heading to fourth quarter implies a 100- basis point sequential decline. Is that looking like conservatism that just offsets if the sales for some reason don't come through where they are? Otherwise, it looks like you -- there's not a real clear reason why the EBITDA margins would sequentially drop.

Yes. Well, I think that's exactly right. As we look at the order book and the backlog, we could hit -- it's going to be better than the midpoint that suggests that it is coming down. But the high end would suggest that we'll continue to be in that over 48% EBITDA margin area.

Okay. And then just the one...

Well, there's nothing systematically changing in the business. I think it was down a little. It just happens to be the mix of the product that goes out in that quarter.

Yes. Okay. And then the only -- last one, on the defense side. Within the segments, I think, Kevin, you mentioned both aftermarket and OE were strong. Any way to clarify which was stronger and by how much?

They're both -- sorry, they're both comparable.

Our next question will come from the line of David Strauss with UBS.

Terry, one for you. I didn't have a chance to work through all the math on the cash balance, but are you implying any sort of change in the underlying free cash flow guidance for the year, which, I think, you were targeting around $800 million?

Yes. No, there's no change. And what we look at from a free cash flow, is trying to hit 50% of our EBITDA after taxes, interest and CapEx. Interest is running higher this year. We may be a touch under that, but it should be pretty close to that 50% from a free cash flow standpoint, which gets you in that $800 million to $850 million range as we kind of define free cash flow.

Okay. And thinking about the way forward, Nick, what would prevent you guys from being able to grow adjusted EBITDA, at least in kind of the low double-digit range on a go-forward basis?

I don't think -- David, I don't want to get back into next year's guidance. That's -- I think we'll put that out when we put it out. We gave you in the last quarter our view of sort of a -- 4-, 5-year trends in that. But I think next call, we'll put the guidance out.

Okay, last one. Nick, you've been pretty consistent in being a little cautious on the commercial cycle overall. Obviously, there's some destocking going on right now. But how are you feeling about kind of the sustainability of the commercial cycle at this point? We've obviously had really good traffic numbers here for quite a while.

Yes. With that -- this is always a risk. You -- the -- absent the destocking, I think we probably feel better about it now than we did 18 months ago. Now whether that translates into anything, who knows? But...

Our next question will come from the line of Hunter Keay with Wolfe Research.

Nick, can you give us a little more color, just a little on the discretionary interior stuff, which, presumably, is just an extension of some of the cabin esthetics that you guys talked about last quarter? Is there a concern that this is maybe a leading indicator for airline spend like what you guys have seen through the course here of the history of your company? Is the -- like it starts with discretionary, and then usually the cuts end up going a little bit deeper. How should we think about this patch of softness vis-a-vis sort of I don't want to say canary in the coal mine per se, but is it a leading indicator for an expectation that maybe there's going to be more to come?

Kevin, you want to take that?

Yes. Hunter, this is Kevin. So when we look at it, the OEM business and the repairs business continues to march along. It's really the refurbishment. That's a United Continental rebranding sort of idea. And those tend to go through peaks and valleys. We've seen this when we evaluated the businesses for acquisition, that they go through peaks and valleys. So we're still winning future refurbishment orders. I referred to that in the -- in my words prepared. But as we continue to win those, I don't see any reason why in the future they -- those won't return. We are seeing opportunities, though, on refurbishments on some of the low-cost airlines around the world, in the Middle East, Asia, India. So there's still opportunity there. I think we're just going through a lull in timing right now.

Okay. And then I apologize if I missed this. This is my last question. Did you disclose what were underlying organic gross margins excluding the acquisition dilution?

Yes.

He's talking about EBITDA.

Yes, I think we've said they're about 100 basis points higher than the...

Than the average.

(inaudible).

Industry average.

Our next question will come from the line of Peter Arment with Robert W. Baird.

Nick, just kind of just a high-level question on kind of the M&A. You mentioned it's a down year. It's obviously down pretty considerably over the last several years. Is it just purely timing and this is M&A? Or did you lose out in some deals? Or are you just not liking the properties that you're seeing? Maybe just a little color on the M&A environment.

Yes, one, I don't think it's down the last couple of years. I think the year before was pretty heavy. I think we bought (inaudible).

Right. No, no, no, I agree with you, yes.

Yes. I -- my -- in '17, my general view is across the industry, it seems to be slow, the M&A activity. I mean, we have -- we see things, but generally the things we like either have been small -- I'd like or I can't really say we didn't like the prices and we walked away from -- for that reason. I would say mostly, the things that we haven't bought, it's because they weren't proprietary enough.

Got it. Just not fitting the business model?

Yes, just not fitting the model. And we're -- we don't feel a need to stretch it. I think we generate plenty of cash and capacity. And as we say, if we don't see something that meets the model, we tend to give the money back to the shareholders. And we're pretty confident that if we need the money later, we'll have it or we'll find a way to come up with it.

Okay. And just to follow up there, Terry, to the -- could you just mention, well, what's the pro forma leverage you expect after the special dividend?

We'll be at probably just under 7x gross and 6.8 net. And that...

And that'd be based on this -- on the 9/30 number.

Yes.

That'd be May to June.

That would be at June. And then at September, that will go down to, call it -- net-net, that will between 6.4 and 6.6 depending on the size of the dividend.

Our next question will come from the line of Robert Spingarn with Credit Suisse.

Nick, I wanted to ask you something high level as well. With all the supply chain discussion and some of the pressure that Boeing and other OEMs are imposing on the suppliers or on certain suppliers, how do you think this affects the M&A environment? And I say this in the context of very large deals being discussed out there in the media. Do you see more consolidation at greater levels? And is TransDigm a buyer or a seller in this environment?

Well, I would say, Rob, the reality is we are either. We're pretty commercial and mercenary, as we should be as representatives of shareholders' money. We -- I would say as a -- well, let me -- I don't know where this goes. Yes, I -- you might think it would generate some more activity, but I can't say it has. We surely haven't seen it. I've seen the same rumor or this big deal that you have. I think when we see something with the right value proposition, well, we're a buyer. And I don't think we're necessarily particularly capital constrained, but we are constrained by that we have to see our kind of return and fit our kind of profile, which is a fairly tight restraint.

But do you think maybe this loosens some larger pieces that might not have been in -- within your traditional aperture?

I mean, Rob, I don't know. I can say we haven't seen it yet.

Okay, maybe it's a little early for that.

Yes, yes.

Second question. And this could be for anybody, but back to something we talked about earlier and last time, just the bookings versus the shipments. And the math behind that might have implied a little bit better commercial aftermarket. Are we going to see these bookings numbers come through? Or am I thinking about it wrong? Do I look at your Slide 6 that Kevin spoke to, and are the bookings really specific to the passenger business and you do it differently in interiors, which is why we don't see the pressure on the bookings that's translating into the pressure on the sales?

I don't know that I can answer that. I think -- but let me take it in some pieces. The passenger business, I think, we feel pretty good about. I think the interior business, we don't believe we've seen the bottom of that yet. I don't think our bookings make us feel great about it. The bookings in the freighter business look pretty good. And I would say the biz jet helicopter, sort of the incoming work is probably roughly consistent with the outgoing, yes.

I guess, Nick, what I'm saying is that the bookings that you've shown us throughout the year would have suggested we would not have a 19% drop in the commercial transport interior business unless those bookings are excluded from the number of bookings, from what is included in your bookings number.

I'm not sure I follow the question, Rob. Everything is around booking number.

So it's all there? So -- okay.

Yes, it's all there. There's nothing excluded from any of our -- our bookings are our total bookings.

Right. So it goes back to you -- I can't remember the -- I don't know if you've given the number for this quarter, but you had been sort of in a 1.1 book-to-ship, at least up through the last quarter, but we haven't seen that 10% type of overall aftermarket growth that would be implied by a 1.1 book-to-ship.

I'm not sure we're apples-to-apples, Rob. And I don't think I can answer your question here. Not that I'm unwilling to. It's just that I'm not sure that I know the answer.

No, no, it's complex, and I think it has to do with what's included in the bookings versus what's included in the sales, in the growth numbers.

So Rob, here is -- because we are strong with some bookings number last quarter, you're expecting higher sales? (inaudible)...

Well, and I think it was more than just last quarter. I think it was the prior quarter. I mean, the bookings have been coming through, I think, at a stronger level than the aftermarket sales. So I was asking you, is that because of the interior weakness is the difference and those bookings aren't counted the same way as everything else?

No, all bookings are counted the same. All bookings are counted the same.

Our next question will come from the line of Ron Epstein with Bank of America.

A big-picture question and then maybe a more detailed question. So I guess it was last week Boeing announced that they're opening this avionics business, that they're going to be a supplier. How do you think, Nick, that, that changes the dynamics in the supply chain, kind of broadly speaking, if they start to do actuators and other bits and pieces of airplanes? I mean, do you think -- I mean -- I'm trying to get a sense, I mean, how do you think about that?

The real answer is I don't know where they go with it and I don't know what the impact is. So far, at least in the businesses that we're familiar with, anything they've done that with has been made-to-print, nonproprietary stuff. I think it'll be a tough-row-to-hoe if they start to move into the proprietary kind of content. They get all kinds of agreements that tangle up and the like. Now where it goes, I don't know. We haven't seen -- we haven't really seen anything in our business yet. In nonproprietary things, you should -- you're probably going to be at risk.

Yes. Yes, that would -- and if I could just kind of then dig down a little further. Why is proprietary going to be such a tough-row-to-hoe for them? I mean, why is that safe to assume?

I think it's -- look, nothing's impossible. It's -- it takes a fair amount of engineering. Typically, the supplier owns the intellectual property. The requalification is fairly lengthy. They're typically tangled up in agreements by platform. They're -- get pretty ugly if you start to try and -- if somebody starts to try and pull out of them.

Got you, got you. And then maybe just a more detailed question. When we look at specifically the refurbishment business. Is that work, a, being delayed, rescheduled, deferred? And is it coming specifically from one region or fleet type? So I guess what I'm driving at, do you think a lot of this is coming out of the Middle East, on wide bodies? I mean, how -- is there any way you can speak to that?

Kevin, there is some softness in the Middle East on that. Certainly, some softness on the wide-body side. But it's specific to refurbishments, rebranding. It's significant fleet-wide overhauls where we're seeing the weakness, so.

Got you. And then maybe one last question. With the fleet of 787s kind of getting bigger out there, there's something over 500 or so flying around and they've been in the fleet for a while, when do you expect to see some aftermarket on those airplanes pick up?

Well, we see some now. Well, I mean, you can almost do the math. This isn't exact, but you can almost calculate the rate, which I just don't know as I sit here. You can calculate the rate at which they get beyond about the 5-year life, and that's probably going to be a pretty good proxy for the aftermarket pickup.

Got you. So just typical standard is the way to think about it?

Yes.

Our next question will come from the line of Matt McConnell with RBC Capital Markets.

Just to follow up on your comments on M&A. You said you didn't see enough proprietary deals or deals that meet your characteristics. Is that -- would you characterize that as kind of the normal lumpiness of deal-flow on a year-to-year basis? Or if you think about the medium and long-term opportunity, are you still seeing proprietary assets that make you think you can -- you have a rich pipeline for the next couple years?

Matt, I think so. When I say I think, one thing I know is predicting the closure rate of deals is difficult. I mean, there's -- you can easily come up with a list of attractive, medium or decent-sized thinks you'd like to buy. But will they close? Will they come up for sale? At least this year, no. In the past, we've seen this. I would say probably 3 years ago, we did almost nothing, and then we had big years in '15 and '16. And this year was a little soft. One of the, I believe, attractiveness of our capital allocation mindset model is that we try hard to get the return back to the shareholders another way if we can't get it by buying stuff in a year.

Okay. All right, great. And then just on the commercial transport interior business. Are you sure that's a market issue? Or has there been any change in the competitive landscape there? I mean, is somebody else winning that work? Or is it -- or are you pretty sure it's just project deferrals?

Kevin, you're going to take that?

Yes, I'm pretty sure it's project deferrals. We haven't seen any indications that any significant pieces of business went anywhere else. It's simply delays of what we had expected.

Our next question will come from the line of Seth Seifman with JPMorgan.

Probably never expected to spend so much time talking about interiors, but I'll ask one more. So the declines that we're seeing, why isn't this, to some degree -- I mean, it seems over the past 3 years, this business is up 50%. Why isn't this, to some degree, just some mean reversion on project work that should be kind of lumpy? And if it's not that, then should we think about the interiors business typically as something that should be one of your best businesses and grow well above average?

I'll try that. The interior -- the retrofit portion of the interior business is -- over time tends to be more cyclical than our other businesses because it's more discretionary. Over time, I suspect, if you take a longer -- long enough period of time, 5 or 10 years, I suspect that, well, it has, on average, the same kind of patterns as the rest of it. But definitely, you can be lumpier.

Right. And so if that's the case, if we've been up 14% on average for the past 3 years, maybe it's not so surprising to see what we're seeing now?

Well, you're going to see a downturn sometime when you're running 14% or 15% a year.

Yes.

Right, right. Okay...

I think -- I would say it came on, frankly, a little suddenly.

Yes.

It did sort of slow down kind of quick, kind of quick. But that's -- no one blows a whistle before you hit the top of a market.

Right. And is your direct customer here the airlines? Or is it another manufacturer or an MRO shop?

The answer to that is all of the above.

Right. Okay, okay. Nick, and then maybe one more. Based on some of the slides you guys have disclosed recently, it seems like the -- your pricing over a period of years in the cargo freight piece of the aftermarket is essentially 0. Can you talk about how that business kind of fits into your model given that sort of unusual pricing dynamic for a TransDigm end market?

I don't -- I have no idea where you're getting those numbers other than I don't -- I don't know because I don't know. I would say in that business, the Telair, which is the bulk of the business, the Telair U.S., United States, it's proprietary stuff and does reasonably well. The containers and the net business is nonproprietary and doesn't do as well. But I don't think it averages up, down or 0.

Right. Okay, yes. I was looking at some of the real growth numbers you guys put out in the May slides and then what you put out today for the pro forma.

Yes, those were different time frames.

Our next question will come from the line of Michael Ciarmoli with SunTrust.

Maybe just, Terry, a point of clarity. I don't know if I missed this. The free cash flow this year, $1.75 billion to $2 billion, but I think you said looking at the capacity going up to -- or, I'm sorry, not the free cash flow this year. I'm looking at the capacity you said going up to $3 billion in 2018 versus what you guys would have in terms of capacity of $1.25 billion at the end of this year. So how do we bridge that gap to get to $3 billion? I think your free cash flow is typically 50% of EBITDA. So what gets you to the $3 billion of capacity, if I heard that right?

You also have to look at the EBITDA of the target, right. We would be able to pick up 7x their EBITDA as part of an acquisition strategy. And that's part of the buildup into that number.

Okay, okay.

(inaudible).

Okay. And then just maybe, Nick, one more on this interiors. If I go back to Rockwell Collins, it sounded like they were starting to see some of their backlog build for sort of retrofit next year. And I think you just said you provide to all of the big manufacturers, airlines, retrofits. What's sort of your lead time? I mean, if they're starting to see their backlog build, I mean, how soon do you guys get orders ahead of a retrofit project?

Well, probably, and this is a real guesstimate, right, thanks (inaudible). The problem is -- with these programs is they tend to stretch out. So the delivery, if it -- when they slow down, if they're going to do them in March, so you expect the order in September. And then suddenly, March becomes May and May becomes July. And that's what we're seeing some of now. Best we can tell, we don't have any project dying.

Our next question will come from the line of Gautam Khanna with Cowen and Company.

To follow up on Rob Spingarn's question earlier, in the aftermarket, what is -- when we think about book-to-ship, what is your average lead time for aftermarket order-to-ship time line?

I don't think I can give you an average. I mean, it's kind of all over the map. Retrofits are different than spare parts and that sort of thing. But I don't think it'd be -- the average is kind of a meaningless number with all our product lines, but maybe, 3, 4, 5 months, something like that.

Okay. No, that's helpful. Also, Nick, I think I heard you say on the biz jet side, it's hard to parse out what's aftermarket and what is OE sometimes. Is that because the pricing is the same? And is the profitability the same on those sales?

Sometimes, it is. Sometimes, it isn't. It depends on part number and the account. So -- and the -- frequently, the biz jet manufacturers control more of it than in other sectors. So when they order, yes, to your point, you can't always tell exactly what it's for. So sometimes, it's hard to parse out inventory fluctuation from aftermarket fluctuation at the OEM, if you follow me.

Yes, I understand. And any sense for how much of the biz jet aftermarket is -- falls into that more amorphous category? Is it like half of it? Or is it...

I think it's more than half. We make our best judgment, and we try and do it consistently. The aftermarket OEM split, we have a consistent way. We do it quarter by quarter by quarter to try and keep some legitimacy for it. But there's a little -- as Kevin said, there's always a little bit of a gray in there. But I don't think it changes the fact...

And just one last...

That it's soft. Whether it's soft by 2%, 5% or 7%, you might argue.

Right, makes sense. One last one, just on the M&A pipeline. Over the next of couple years, do you think there's going to be a better pipeline for defense-related acquisitions or commercial aero? And do you think the valuations will be much different between the 2 segments?

Obviously, I don't know the answer to that. I would say if you look over the last few years, there surely have been more defense stuff came up than it had come up in the 2 or 3 years before that. And the prices moved up. Whether that will continue, I just don't know.

Our next question will come from the line of Drew Lipke with Stephens.

One question just on the interiors, just to round that out. How much of that business do you view as traffic or usage or maybe spares driven as opposed to how much is rebranding or refurbishment or retrofit? Is it all retrofit?

No, it's not all retrofit. There's an existing OEM content. There's the repairs of things that get damaged during usage, which is kind of what you were referring to. And then there's the refurbishments, rebranding, which are esthetic, can take longer to plan out. So what goes through the wear and tear, the -- that gets repaired as usual, and you might expect that to follow with the usage of the airline.

And do you know the percent mix between those?

I would be speculating, but I would guess it's probably 1/3. 1/3, 1/3 and 1/3. But I'm -- that's up for revision, I guess, as I dig into that. But that's my thought at the top of my head here.

Okay. And then just second question. I guess the last couple quarters, you had talked about look-through sales at the distributors being up, I think, double digits. And I'm curious, what sort of sell-in versus sell-through component did you see at the distributor level here in the quarter? And did you see any kind of inventory build in the quarter?

It was similar to previous quarters. So it was up, as before. We continue to trend upwards on the look-through sales. I didn't call it out this time, but it continues to move in the right direction.

But I think what he's -- Kevin, is it true that the -- there, the increase year-over-year in their shipments for this quarter, well, aren't -- look relatively close to our increase year-over-year?

Yes, that's right. That is true.

And I'm showing no further questions at this time. So now it's my pleasure to hand the conference back over to Ms. Liza Sabol, Investor Relations, for some closing comments or remarks.

Thank you for participating in this morning's call, and please look for our 10-Q that we expect to file tomorrow.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and we may all disconnect. Everybody, have a wonderful day.